Euro

A basket or composite currency developed by the European Economic Community (EEC) in the 1970s and 1980s as the community’s accounting currency. The currency then became used in commercial transactions, although it did not exist in note or currency form. It was used by members of the community to offset the often volatile effects of the U.S. dollar, the world’s major reserve currency. As the EEC became larger, the need for currency stability against the dollar and for a common transaction currency prompted the development of the contemporary euro.

The common currency of the members of the European Union was created on January 1, 1999, not only to provide the European Union with a common currency, but also to provide some insulation against movements in the U.S. dollar, which had caused distortions in the past against the individual currencies of its members. It included Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. Greece joined in 2001, while the United Kingdom and Sweden have kept open their option to join. In a fall 2000 referendum, Denmark decided not to join.

Since 1999, the exchange rates of the participating countries are fixed. Capital market transactions (including the bond and equity markets, the foreign exchange markets, and the interbank market) were run exclusively in euro, while retail transactions with notes and coins were conducted in national currencies. In the first two months of 2002, national currencies disappeared completely, replaced by euro notes and coins.

With the introduction of the euro, the national central banks became part of the European System of Central Banks (ESCB). The European System of Central Banks comprises a European Central Bank (ECB) located in Frankfurt (Germany) and the national central banks of each country participating in the euro. The governing council of the ESCB formulates the monetary policy. It is made up of the governors of each central bank participating in the euro and of the members of the executive board of the European Central Bank. The executive board implements the monetary policy, giving the necessary instructions to the national central banks.

The creation of the euro cannot be separated from the Single Market Program, another part of the February 1992 Maastricht Treaty on the European Union. The 1992 program provides for the free flow of goods, capital, and persons. Resistance to the creation of the single market was reduced by the single currency as it prevents “beggar-thy-neighbor” type of competitive devaluations. The European Monetary Union (EMU) is therefore the cement of the single market, which by integrating previously fragmented markets allows firms to realize gains in productivity and competitiveness.

Four major benefits of a single currency were identified: reduction in transaction costs (estimated at 0.4 percent of gross domestic product), reduction in foreign exchange risk, increased competition in a more transparent market, and emergence of an international currency competing with the U.S. dollar. A potential cost of the EMU mentioned by several economists, is the sacrifice of national monetary autonomy and the possibility of controlling interest rates or adjusting exchange rates to restore competitiveness.

In its first year of existence, the replacement of national currencies by the euro had a significant impact on financial institutions. Firms or governments of a particular country were accustomed to turn to domestic banks to issue bonds or shares since, being denominated in local currency, these securities would be distributed and sold primarily to local investors. This is the wellknown home bias according to which investors have a preference for securities denominated in their own currency. Moreover, issuers had difficulty in raising very large amounts as domestic financial markets were fragmented. With the euro in place, the dynamics of underwriting and placement changed completely. As a consequence, domestic banks lost one source of competitive advantage: a captive home investor base. Moreover, the liquidity of the market driven by a larger pool of investors increased very rapidly. Euro-denominated bonds amounted to euro 812 billion in 1999, exceeding by 49 percent the amount of U.S. dollar–denominated international bonds. Very large issues exceeding euro 5 billion are frequently observed. The consolidation of the banking industry followed rapidly.

The creation of the euro has raised concerns about the functioning of the international monetary system with three major currencies—the euro, the dollar, and the yen. There has been a fear that the absence of a political will to anchor the exchange rates would lead to excessive volatility. In the early years of the euro, economic growth differential in favor of the United States has induced a large appreciation of the U.S. dollar. However, the new currency served a serious integrative function by eliminating the need for businesses to constantly turn to the FOREIGN EXCHANGE MARKET, using the euro as a common currency instead.

Euro

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